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Swaps Reincarnate Boost Debt Bets

Financial innovation picks up as investors look for ways to boost returns.

Derivatives that helped inflate the 2007 credit bubble are being remade for a new generation.

JPMorgan Chase & Co. is offering a swap contract tied to a speculative-grade loan index that makes it easier for investors to wager on the debt. Goldman Sachs Group Inc. is planning as much as 10 billion euros ($13.4 billion) of structured investments that bundle debt into top-rated securities, while ProShares last week started offering exchange-traded funds backed by credit-default swaps on company debt.

Wall Street is starting to return to the financial innovation that helped extend the debt rally seven years ago before exacerbating the worst financial crisis since the Great Depression. The instruments are springing back to life as investors seek new ways to boost returns that are being suppressed by central bank stimulus. At the same time, they’re allowing hedge funds and other investors to bet more cheaply on a plunge after a 145 percent rally in junk bonds since 2008.

“The true sign of a top is when you have these new structures piling up,” said Lawrence McDonald, a chief strategist at Newedge USA LLC, and author of the book “A Colossal Failure of Common Sense” about the 2008 demise of Lehman Brothers Holdings Inc. “At the top of the market in 2007, there were these types of innovation and many investors didn’t realize about it at that time. These products are a clear risk indicator.”

The new products are also a reflection of investor confidence in the economic outlook. U.S. gross domestic product is forecast to expand at an annualized rate of 3.10 percent this quarter and next as the labor market strengthens, according to the median estimate of about 75 economists surveyed by Bloomberg.

JPMorgan is marketing total-return swaps that are tied to Markit’s iBoxx USD Liquid Leverage Loan index, a benchmark for the $750 billion leveraged loan market, according to a July 11 Morgan Stanley report. The swaps allow an investor to pay a fee in exchange for receiving the total return on the index at the expiration of the trade. If the measure posts a loss, the investor compensates the counter-party to the trade.

Total-return swaps allow investors to amplify gains because they can wager on a large pool of debt while setting aside a relatively smaller amount of collateral to back the trade. While the derivatives have been around for years, these are the first to be tied to the index, providing investors a benchmark that can fuel faster and easier trading similar to how the credit- default swaps market ballooned in the years before the financial crisis.

Jessica Francisco, a spokeswoman for JPMorgan, declined to comment.

Future ‘Problems’

“Some funds have to use more leverage to get the sort of returns that their investors expect, Peter Tchir, Brean Capital LLC’s head of macro strategy in New York, said in a telephone interview. ‘‘We are moving into a phase where there will be more esoteric products. It does start setting up more problems for the future.’’

The Federal Reserve’s extraordinary stimulus measures unleashed after the credit crisis to spur growth, have pushed investors to sacrifice safeguards in their search for returns as benchmark interest rates remain close to zero for a sixth year. Pacific Investment Management Co. popularized the term ‘‘new normal’’ to describe an era of below-average economic growth and low interest rates following the financial crisis.

The new swaps will also feed a growing appetite to hedge against losses in leveraged loans, Sivan Mahadevan, a strategist at Morgan Stanley, wrote in the report.

Investors withdrew $1.5 billion from U.S. funds that buy leveraged loans in the week ended Aug. 6, the largest weekly outflow in about three years, according to data provider Lipper.

Goldman Sachs plans to sell its first structured bonds with a 1 billion euros offering, according to a June 24 report from Standard & Poor’s. The notes, which may be sold in September, are backed by a revolving pool of fixed-income assets, including asset-backed securities.

The proposed financings have been compared by analysts at Societe Generale SA to collateralized debt obligations, that fueled the housing boom by packaging risky loans into securities that were sold to investors, often with top AAA ratings.

The securities, the first of their kind, also use a total return swap and have features similar to covered bonds, a type of secured note backed by mortgages and public sector borrowings. The financing, backed by Goldman Sachs and Japan’s Mitsui Sumitomo Insurance Co., would be rated AAA, according to to S&P.

Swaps ETF

‘‘The current state of play where yields are very low and there are more redemptions than issuance in certain assets, such as covered bonds, leave investors looking for innovative investment opportunities, so long as they pay up,” said Cristina Costa, a senior covered bond analyst at Societe Generale in Paris.

Sophie Ramsay, a spokeswoman for Goldman Sachs in London, declined to comment on the notes.

ProShares started trading an exchange-traded fund last week that allows individual investors to bet against junk bonds with credit-default swaps. Credit-default swaps allow buyers to wager on the credit market or hedge their exposure.

The ProShares CDS Short North American High Yield Credit ETF, which is listed on BATS Exchange Inc. under the ticker WYDE, will invest at least 80 percent of its assets in credit swaps tied to a benchmark index, according to a July 23 filing.

IntercontinentalExchange Group Inc. was pitching derivatives contracts that would allow investors to wager on U.S. homeowner defaults, Bloomberg News reported in May.

The emergence of new derivatives is reminiscent to the period leading up to the crisis, said Stephen Blumenthal, the chief executive officer of investment firm CMG Capital Management.

“Wall Street has always had a habit of piling on products when there’s an appetite for the asset class,” Blumenthal, who oversees $600 million in assets, said in a telephone interview. “That’s under the Code Red category.”

‘Frothy Environment’

The riskiest kind of derivatives added to losses for investors during the credit crisis. The investments included so-called synthetic CDOs that during 2006 and 2007 loaded their holdings with credit swaps linked to the debt of financial companies including Lehman, Washington Mutual Inc. and bond insurer Ambac Financial Group Inc., all of which collapsed amid the 2008 market seizure.

“You didn’t know the depths of the risk you really had,” Blumenthal said of the subprime paper rolled up into AAA-rated products. “We might not be there yet but we are in a frothy environment today.”

Former Fed Chairman Paul Volcker has blamed credit swaps and CDOs for taking the financial system “to the brink of disaster.”

“You can be near certain that some big funds are going to a bank right now and saying I want to go short and how can we create a vehicle that allows us to put on a big-sized trade,” Newedge’s McDonald said. “The genesis of the next crisis will not be on the sell side. Likely, it will come at us from where there’s not enough liquidity, for many parts of the buy side.”

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